We have written about our investment portfolio more than once and the purpose of this post is not to go over that again. What we are going to get into is how we (a) plan to position our portfolio for early retirement and (b) our withdrawal strategy once we get there.
There are many great articles out there on each of these two topics. Indeed, probably more articles than there are actual mutual funds available – and that is a lot. The Physician on Fire has described his Investor Policy Statement, the Bogleheads forum must have thousands of articles on asset allocation strategies and Wade Pfau has documented in many peer reviewed articles the dizzying array of options available to the early retiree on withdrawal strategies. To be honest, the amount of information out there can be overwhelming. Here is a “Simple Simon met a PIEman” approach that tries to distill it all down to something that we and you can understand. Or as Einstein famously said:
Everything should be made as simple as possible, but not simpler.
First of all, here is a summary of our plans.
- Retire early (Mr. PIE age 51; Mrs. PIE age 45) with two boys in elementary school (age 11 and 9).
- Target date is July 3, 2018.
- Relocate the family to our mountain home in Northern New England.
Asset Allocation at Early Retirement:
- Portfolio target with approximately 50:50 split between taxable and tax-deferred investments.
- Portfolio mix to be 65% equities, 25% bonds, 5% REIT, 5% cash.
- US to ex-US equities allocation ~5:1 with international equities spread across total international, developed and emerging markets.
Early Retirement Income Sources:
- Company pension (Mr. PIE) starts paying out at early retirement as “income floor” that will cover ~35-40% of expected annual expenses in retirement.
- The dividends from our taxable account will be directed to our bank checking account on a regular basis. Current asset allocation mix in our taxable account has a weighted dividend yield of 2.65%.
- Sell taxable assets from equities or bond bucket according to CAPE (Cyclically Adjusted Price to Earnings) ratio or Equal Withdrawal for each. We’ll get into the meat of this later.
- Mrs. PIE may elect to bake and decorate a spectacular cake or two, sell them and direct any side hustle profits to family needs such as kids college funds or Mr. PIE Sunday afternoon adult beverage ventures…
- Conservative investing approach, which has actually moved from ultra-conservative to just boringly conservative. Sleeping extremely well is the name of our game. It is as simple as that.
- 529 accounts are not factored into our asset allocation or withdrawal plan. Those funds are already spoken for.
- Taxable account is with Vanguard in low cost passive index funds.
- Our employer sponsored 401K’s will each be rolled over into Vanguard at separation from service and assigned according to the equities/bonds/REIT allocation described above.
- We don’t intend to invoke any 72t distribution or Roth conversion strategy with our tax-deferred investments. We will however assess RMD’s (Required Minimum Distribution) projections well in advance of them kicking in at age 70.5.
- Minimized through (a) zero mortgage (b) travel hacking to fund majority of vacation budget and (c) living in a location within a tax-friendly state – i.e. low property taxes and no state taxation of pension income. Our tax obligation is projected to be very low according to running the numbers through tax-rates.org.
The PIE Withdrawal Strategy
Financial planning gurus like Wade Pfau and Todd Tressider have written and spoken about different withdrawal strategies. Go listen to this podcast and this one for great discussions between Wade and Todd on different withdrawal strategies to support income generation.
It was also very timely that Fritz over at the Retirement Manifesto outlined a common approach known as the Bucket Strategy that he is putting in place. On that very post, Mr. PIE commented on the approach of family PIE as being roughly similar to his. Indeed we also hold some of the same index funds within the different buckets. Please go take a look at his post that featured on RockStar Finance (Congrats Fritz!) last week. Anyway, not to recreate what Fritz was describing, here is a summary of “our buckets” with some nuances that are unique to us and perhaps others.
This is the cash bucket that we described above as 5% of our portfolio. Our existing emergency cash on hand will be increased using a portion of the proceeds from the sale of our primary residence in 2018. The number of years of expenses depends on your risk tolerance and factors such as other base income sources (e.g. pension). As we described above, we will have a pension thus our cash on hand has that factored in and we will have a lower amount in this bucket than is typical for an early retiree with no pension income. For the well documented Sequence of Returns risk, this is why holding cash is king to avoid selling equities or bonds in a prolonged bear market.
Bucket 2, Bucket 3
Here is where it gets tricky.
Where are you going with this, Mr. PIE?
Is there a hole in your bucket(s)? Are they going to empty too fast?
Hopefully no holes, just some reasonable arguments perhaps. Let’s go.
We described above that our asset allocation with be a mix of safer asset classes like bonds (typically Bucket 2 in the traditional bucket approach) and riskier asset classes like equities (typically Bucket 3). Beyond our income floor pension (barring a scandal of Enron proportion and Mr. PIE’s company going out of business, we expect to continue to receive this in retirement!) and regular payout of dividends from our taxable account, we will need to sell some assets to meet our annual expenses.
The important question to understand is – which asset class should we sell on an annual basis?
Again, this is where some fine withdrawal strategy research is out there on the interwebs. Darrow Kirkpatrick who blogs at Can I Retire Yet did some truly excellent work on this very topic. To summarize, Darrow used historical data to test a portfolio of equities and bonds against different withdrawal strategies. In his original article, he tested six different methods based on a 50:50 mix of equities : bonds using a $1M portfolio and 4% withdrawal rate. He then computed the results for each 30-year retirement span from 1928. There were surprising results across each of the strategies. The table below highlights four of the strategies and the ending portfolio value after 30 years.
In some subsequent work, Darrow added in different asset allocation portfolios (60/40 and 80/20) and also incorporated an annual rebalancing strategy into each method. The bottom line is no different – CAPE strategy still wins. There is no CAPE Fear.
So what is CAPE (Cyclically Adjusted Price to Earnings)?
CAPE is a valuation measure usually applied to the S&P 500 and is defined as price divided by the last ten years of earnings, adjusted for inflation. It is conveniently available with the click of a mouse and heading over to this web-site. The current Shiller PE ratio is 26.5 compared to the median of 16. Higher values typically indicate stocks may be overvalued. What it is telling the early retiree to do according to the CAPE withdrawal strategy is to sell equities at the end of 2016, assuming the ratio does not move significantly. In practical terms, if you have a $1M 50:50 equities:bond portfolio with $40K in expenses and need $20K to add onto the $20K of dividends that a $1M portfolio throws off, simply sell $20K worth of equities. Simple as that.
And if you don’t believe what Darrow has to say about using CAPE as part of a long term withdrawal strategy, go read this article from another great financial planning researcher Michael Kitces on other ways CAPE can help in the context of your retirement plans.
The data in the table above provides a few simple conclusions:
- All four strategies provide a sizeable ending portfolio after 30 years.
- Yet there are startling differences in ending portfolio value. In fact >$4M from just the four different methods described above!! That is some serious moola.
- Adopting the CAPE strategy appears to afford a significantly larger portfolio through retirement and ultimately to pass on as legacy to children, extended family and/or charity. Who wouldn’t want either of those scenarios?
- The equal withdrawal method is certainly the simplest if you are too lazy to click a mouse and go over to the Shiller site. Any retiree should have ample time to fire up their lap-top or mobile device and find the current PE ratio. Simple as that.
Market headwinds will change over time. Past performance is no guarantee of future performance. This is stating the obvious. You know that flexibility in your spend is the adaptability factor that needs to be invoked depending upon the behavior of the market. And ultimately how you manage the trajectory and size of your portfolio.
Unless a better looking strategy materializes in the retirement planning literature, the CAPE method seems like a very powerful way to go. Or do you see any major impediment to adopting this strategy?
Of course, nothing is ever simpler. Perhaps just as simple as possible.
For those in early retirement or approaching it, what are you doing in terms of a withdrawal strategy? What do you make of the research and findings behind the CAPE withdrawal strategy?